In my previous post on the Volcker Rule, I admittedly glossed over the real issue in my second prediction. This issue is important, but it’s also reasonably complex (way too complex for some people, I suspect), and it requires some context and explanation to fully appreciate.

The statutory text of the Volcker Rule contained a glaring flaw: the statute prohibited proprietary trading by basically defining everything as “proprietary trading,” and then carving out exemptions for everything else. This was a colossal mistake for a variety of reasons, but the most important reason is that rather than having the regulators simply define “proprietary trading,” it put the regulators in the position of having to define every form of legitimate trading that banks do — underwriting, market-making, hedging, etc. Obviously, that’s a much, much more difficult task, and one that’s significantly more likely to lead to problems due to gaps — whether intended or unintended — in the proposed rule’s exemptions. It’s hardly a targeted solution to the problem of government-backed prop trading, to say the least. (I imagine the ultimate blame for this lies with someone in the Legislative Counsel’s office, although Merkley and Levin’s offices bear some blame here too, as they were clearly in way overtheir heads during this entire process.)

‘Flipping the Presumption’

The upshot of this is that it creates a presumption that all trades are prohibited prop trades, unless proven otherwise. What the banks want to do is to flip the presumption — instead of regulators scrutinizing whether each trade falls into one of the nine “permitted avtivities” exemptions, regulators would be scrutinzing whether each trade is a prohibited prop trade.

Whether flipping the presumption would dilute the strength of the ban on prop trading depends entirely on the quantitative and qualitative metrics that regulators ultimately use to identify prohibited prop trades. The right metrics would appropriately identify prohibited prop trades, while the wrong metrics could either identify too many trades as prop trades, or too few. But that’s where the debate would shift — or rather, should shift — if the regulators flipped the presumption. (The metrics described in the proposed Volcker Rule would, if anything, be overinclusive, and would require the regulators to apply some judgment to flagged trades — which I think is appropriate.)

Now, regulators only have so much discretion here. The statute is the statute, and flawed though it may be, regulators still have to work within its confines. But there are ways to effectively flip the presumption.

One way to do this is to define the main exemptions (market-making, hedging, and underwriting) very broadly, but include a carve-out for trades done for the “trading account” — which is, bizarrely, where the real definition of proprietary trading is located in the statute. The effect of this would be to allow regulators to focus on whether a bank’s trades exhibit the characteristics of trades done for the “trading account” (i.e., prop trades), based on the quantitative and qualitative metrics the regulators have identified, rather than focusing on whether each trade can fit into one of the defined exemptions. In other words, the presumption would be that a trade falls into the market-making or hedging exemptions, unless the regulators believe otherwise.

This is basically what I predicted the regulators would do in my previous post — although, crucially, I limited my prediction to the market-making exemption, and I said that the regulators would make this an “alternative” market-making test. A broader market-making exemption with a metrics-heavy carve-out for prohibited prop trading would go a long way toward: (a) alleviating concerns about the Volcker Rule’s impact on market-making without necessarily diluting the prop trading ban; and (b) making the regulators’ task a lot less daunting, and a lot less likely to cause unforeseen and unintended disruptions to the financial markets.

About Me

I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

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